Options, Futures & ETFs, Oh My!

February 06, 2018

ETF Options Vs. ETFs
Options are now available on more than 600 ETFs. But one important thing to remember about ETF options is that the size and liquidity of a given fund is no indicator of how large or small its options market will be. In fact, some smaller ETFs have vibrant options markets, while some of the largest ETFs have anemic ones.

Figure 1 includes 2017’s top 10 largest ETF options contracts of 2017 on Cboe, the largest U.S. options exchange.


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By volume, the top two ETF options markets in 2017 were for options on the SPDR S&P 500 ETF Trust (SPY) and the PowerShares QQQ Trust (QQQ), which are the largest and eighth-largest ETFs, respectively.

But the iPath S&P 500 VIX Short-Term Futures ETN (VXX), whose options had the fourth-largest trading volume in 2017, doesn’t even crack the top 100 exchange-traded products in terms of assets under management. Neither does the ProShares Ultra VIX Short-Term Futures ETF (UVXY) or the SPDR Oil & Gas Exploration & Production ETF (XOP).

Meanwhile, the second- and third-largest ETFs, the iShares Core S&P 500 ETF (IVV) and the Vanguard Total Stock Market ETF (VTI) had only middling volume in their ETF options, coming in at the 153rd- and 113th-largest markets, respectively.

In fact, it’s best to think of ETF options liquidity like ETF liquidity: When placing a trade, what matters isn’t just the liquidity of the underlying or just the liquidity of the ETF, but both at once.

“If you’re trading options on ETFs, one should look at both the volume of the option and the volume of the underlying. Ideally, you’ll have a decent amount of both,” said Moran.

Futures-Based ETFs
Once a novelty, futures-based ETFs are now commonplace. Futures are held by everything from commodity and currency funds to volatility products and leveraged and inverse funds, even many alternatives ETFs.

For good reason, too: Like with options, investing in futures-based ETFs is usually much cheaper and easier than investing in individual futures directly, where margin requirements alone can run investors tens, even hundreds of thousands of dollars.

“Futures-based ETFs open up markets that were once much more difficult to access,” said Kevin Davitt, senior instructor for Cboe’s Options Institute.

How Futures-Based ETFs Work
Futures-based ETFs come in many shapes and sizes. Some go all in on the front-month contract for a single asset, while others hold a broad basket of contracts across expirations or assets. Some algorithmically select contracts to optimize costs or momentum, and others use factors and alternative weighting schemes to diversify their exposure.

Most futures-based ETFs, however, go long some particular contract or set of contracts. To do so, the fund manager must “roll” the ETF’s futures, meaning they must sell expiring contracts and move into the next appropriate ones. This incurs some cost or profit, known as the “roll yield.”

If nearer-term contracts are more expensive than longer-dated ones (meaning, roll yield is positive), then that futures market is said to be in “backwardation.” If, however, nearer-term contracts are less expensive than longer-dated ones (meaning, roll yield is negative), then the market is in “contango.”

Essentially, markets in contango are ones where investors expect higher prices tomorrow than they see today; energy markets, like crude oil, are particularly contango-prone. Markets in backwardation, however, are ones where investors expect falling prices on the horizon. Many agricultural commodities, for example, move in and out of backwardation according to seasonal fluctuations in demand.

How To Mitigate Contango
Though little can mitigate unfavorable moves in a future’s spot price, what an ETF holds can have significant impact on its roll costs. 

A front-month-only futures ETF, like the United States Oil Fund LP (USO), offers the closest possible exposure to spot prices, but it’s also most exposed to the ill effects of negative roll yield, since it needs to roll contracts more frequently. If contango is persistent, it can erode gains from beneficial spot price moves.

ETF issuers have come up with two main alternatives to mitigate persistent contango. The first is to select futures contracts across some number of expiration dates. This somewhat minimizes roll cost, because the ETF is only ever rolling some fraction of its total portfolio at a time. The WisdomTree Continuous Commodity Index Fund (GCC), for example, does just this, holding contracts across the nearest six months in an equal-weighted basket. 

The problem is, the longer-term the contracts, the more prices will deviate from spot. Also, since longer-dated contracts tend to have less volatility, there will subsequently be less volatility premium to capture.

The other solution is to use an algorithm or rules-based process that selects contracts for optimal exposure, such as selecting the next contract by whichever one has the most favorable roll yield. Many commodity ETFs now take this approach, including the PowerShares DB Commodity Index Tracking Fund (DBC) and the United States Commodity Index Fund (USCI). This approach too can diversify the ETF’s exposure away from spot and sacrifice volatility premium, however.

“The moral is,” said Davitt, “know what your ETF holds.”

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